Monday, March 30, 2009

Intelligence and Integrity

“Here only a natural order of nobility is recognized, and its motto, without coat of arms or boast of hearaldry, is ‘Intelligence and Integrity.’”William H. Whyte, Jr., in The Organization Man citing Henry Clews, in 50 Years on Wall Street

More often than not, we’re not as smart as we think we are. We misjudge risks, or create Rube Goldberg solutions to the simplest of problems. While intellectual failures are humbling, they’re also learning opportunities. Of course, we learn only if we’re not so full of hubris that we deny responsibility, and also that we possess sufficient situational awareness to recognize when our approach to a solution is perhaps excessively complex. Still, though, like Wile E. Coyote, we can dust ourselves off and go back to the ol’ drawing board when we commit an error of intelligence.

But failing a test of integrity is another matter. Society is founded on basic trust: there is an expectation that the person the other side of a business agreement will fulfill their obligations, just as there is an expectation that each person will honour their contract with society to not violate the law. We can assign a risk factor that a certain number of “defaults” will occur, but that rate of default is, historically, very low. This gives society a basic integrity. Integrity is crucial, because it levels the playing field so that intelligence rises to the top.

However, when there is high counterparty risk at the most fundamental of levels, society fails to function. As a result, we make adjustments, so that the basic trust we would normally extend is not misplaced. For example, as consumer products expanded, we’ve seen increasingly sophisticated product packaging to prevent tampering and theft (thus increasing confidence in the integrity of the basic consumer purchase). Similarly, as more people travel, we’re subjected to all kinds of inspection and interrogation to ensure safety of travel (thus not discouraging people from travelling). And the increase in technology has been accompanied by its own set of threats, ranging from theft to outright destruction of our data, and counter-measures such as phishing filters and virus protection, to make it viable to use this technology.

Today, we face a global financial meltdown. Much of the wealth destruction we’ve experienced was caused by a failure of intelligence: inadequate risk models, incomplete accounting rules, lazy efforts by investment professionals, and many other things have created a loss of wealth which the world won’t recover any time soon. But there is also a lapse of integrity, with everything from falsified documentation supplied in mortgage applicastions, to fraudulent investment schemes (most famously that of Bernie Madoff). The total wealth destruction caused by the blatantly malicious is no small sum. No doubt that financial services will undergo the same phenomenon as consumer products, travel and technology as they come to grips with different means of reducing the opportunity for malice.

The bonds of trust are constantly under siege, in all walks of life. This means no small number of people dedicate their life’s energy not to advancing the knowledge of the world, or enhancing the quality of life, but to preventing one person from injuring or exploiting another. Entire industries exist to ensure the success of the most basic of transactions.

In a world that rewards “now” (e.g., book revenue for commission now, get cash flow to pay the bills now, etc.) the equation behind many transactions is distorted. Somebody may aggressively book revenue because it pays the bills, even if that revenue systemically destroys the capability of the firm to execute (e.g., a firm contracts for work that is unattractive to highly talented employees, who simply quit). Knowing that a firm with which you do business is focused on revenue at the expense of capability is something that would materially affect your willingness to do business with them, because a company gutted of talent is a less capable business partner.

Compounding the “now” mentality, the rise of relativism has made it possible for people to justify nearly any behavior, while the expansion of our “we’re all winners” culture has made us less able to deal with our own shortcomings.

What this means is that for anything in which we engage, we must always be wary of the motivations of counterparties (and in many electronic transactions, an “uninvited party.”) We must look not just at the transaction itself, but at the motivation behind the transaction. In short, we may trust, but we must also verify.

In a trusting world, we can all focus our intelligence to advance the greater good. In an untrusting world, we must allocate a great deal of our intelligence to watching our back. An investment may be highly rated or highly recommended, but it’s up to the buyer to be satisfied with the rationale behind that endorsement. Indeed, lots of people had the opportunity to invest with Madoff or buy structured credit securities backed by all kinds of strange instruments, but refused because they didn’t fully understand how the numbers worked.

Children are naturally trusting. They will extend trust to those around them. But we have to teach them to take nothing for granted. They must not only understand the context of a situation, but have sufficient insight into human behaviour so that they recognize the potential for malice. They must similarly be prepared to subject themselves to the same level of scrutiny to anybody with whom they do business.

As the great moderation gives way to a period of volatility and fear, integrity makes a person a bright light in a storm, and therefore an attractive counterparty for all kinds of situations, commercial and otherwise. It means extending that integrity only to worthy counterparties, and that can mean some very difficult decisions. However, if we behave in a trustworthy way, and if we surround ourselves with people who are trustworthy, our intelligence is largely the determining factor in our path through life.

Needing to navigate a tapestry of duplicitous relativists is not best use of our life’s energy. Better that our children learn how to position themselves so they can concentrate on the value that they can bring into the world.